Netflix Continues to Lower the Bar

 Netflix (NFLX) reported disappointing results Tuesday afternoon. Domestic subscriber growth of 1.1 million fell short of its previous guidance by about 200,000, and perhaps more important, its projected net additions of 5 million for 2012 will fall short of its earlier target of 7 million. We've learned to give little credence to management estimates, given its record of not meeting its targets. The stock is under pressure today, following a recent pattern of the share price moving higher between quarters and then tanking when the results are announced. We won't pretend to know why this occurs, but our best guess is that the story sounds good until the market gets another peek at the updated financial results. We're maintaining our $55 fair value estimate at this time and believe there are plenty of holes in Netflix's strategy.

Overall revenue was up 10% to $905 million. The overall operating margin of 1.8% was dragged down by a loss of $92 million from the international business. One of the pillars of our negative view on Netflix is that the company is wasting capital in international markets. We think the company is spreading itself too thin and international expansion will generate losses for much longer than the management team believes. Once again, CEO Reed Hastings reiterated that the company plans to invest in additional countries, once the overall company reaches break-even, which signals another few years of minimal overall net income. We think investing profits earned in the United States into international markets is a mistake, as we think Netflix has no competitive advantage overseas and the best video content will remain in the pay TV ecosystems.

While we disagree with many of the views shared by management in its quarterly letter, we value having its insights and thoughts documented for our review. A few of the major disagreements we have include the reason for the slower-than-expected domestic streaming growth and Netflix's expectation that its business has the potential to become 2-3 times the size of HBO (we peg it at 29 million subs) in the U.S., which implies 58 million-87 million. If the company is only adding 5 million subs to reach about 27 million by the end of this year, we question how it can reach this lofty target. We see competition increasing significantly over the next decade, primarily from pay TV distributors like  Comcast (CMCSA) that will allow customers to stream both current and library content. Also, management's placing blame on its damaged brand (due to the price increase last year) for disappointing growth is starting to wear thin, as we believe consumers who want video content will go where they see the best value. If its customers are plowing through Netflix's library at the fast rate that management claims, at some point subscribers will run out of content to watch and quit the service.

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